On this website Toby Baxendale presented his plan for monetary reform. He offered a reward of £1000 for anyone who can provide a logical reason why it won’t work; naturally this provoked a lot of discussion. In my opinion Toby’s plan has a major problem, and I discussed this with Toby and the Cobden Centre team over email. Toby doesn’t agree that I’ve found a major flaw in his plan. However, we both think that the debate should be opened up. This article summarises the discussion we’ve had so far.
The Cobden Centre recognize the need for monetary reform, as do I. Reform of money and banking is urgently needed to avert future economic crises. I also agree that Austrian Economics provides a sound understanding of the issues. However, I doubt that the Baxendale plan could be successful. In my opinion if the plan were enacted there would be a burst of price inflation immediately after. The reasons for my concern come from simple economic theory.
What Task Does Money Perform?
Ludwig von Mises described the job of money as follows:
“What is called storing money is a way of using wealth. The uncertainty of the future makes it seem advisable to hold a larger or smaller part of one’s possessions in a form that will facilitate a change from one way of using wealth to another, or transition from the ownership of one good to that of another, in order to preserve the opportunity of being able without difficulty to satisfy urgent demands that may possibly arise in the future for goods that have to be obtained by way of exchange. So long as the market has not reached a stage of development in which all, or at least certain, economic goods can be sold (that is, turned into money) at any time under conditions that are not too unfavourable, this aim can be achieved only by holding a stock of money of a suitable size.” 
What Tasks Do Bank Accounts Perform and How Do They Work?
The economics of banking is important here because bank accounts are pivotal to the Baxendale plan. A balance in a bank account that provides on-demand payments and transfers provides services that are similar to those of note and coin money. Again, Mises gives a good description of the situation:
“The cash balance held by an individual need by no means consist entirely of money. If secure claims to money, payable on demand are employed commercially as substitutes for money, being tendered and accepted in place of money, the individuals’ store of money can be entirely or partly replaced by a corresponding store of the substitutes.” 
In Mises’ terminology notes and coins are money-in-the-narrower-sense. A bank balance in an on-demand account is a money-substitute. Money-in-the-broader-sense is the sum of money-in-the-narrower-sense and money-substitutes such as bank account balances.
A balance in a bank account is a debt that the bank owes to the account holder. As Toby writes in his article “… your bank-statement is a mere IOU”. Banks invest the money deposited into accounts, often in loans and mortgages. Banks keep only a small amount of “reserves” of money-in-the-narrower-sense. The diagram below shows the situation:
The Baxendale Plan
Toby Baxendale’s plan is based on a similar plan by Jesús Huerta de Soto, an economist of the Austrian School from Spain. The essence of the Baxendale plan is that it makes all money-substitutes into money-in-the-narrower-sense. Lorry loads of notes are shipped to banks to make this happen. After the plan is enacted a bank statement that says £550 means that the bank is holding a corresponding £550 in notes and coins. The legal relationship between the customer and the bank is altered, after the plan the customer is no longer lending to the bank, instead the bank is acting as custodian of the customer’s cash. The bank becomes a “money warehouse” . Since the balances of on-demand accounts become possessions of the customer, not debts, they no longer appear on the bank’s balance sheet. So, after the plan the banks will have an asset surplus. Rather than allow the banks to profit from this Toby intends to use these assets to pay off the national debt. Specifically, Toby proposes that the asset surplus be removed and put into a mutual body to pay off the national debt.
Bank Services and Interest Payments
A balance in an on-demand account isn’t just a money-substitute, it entitles the account holder to extra services from the bank. In Britain banking services such as payments and transfers are free, some on-demand accounts also pay interest. A balance in an on-demand account provides the holder with two things. Firstly, it provides a reserve of wealth that may easily be exchanged, just as notes and coins do. Secondly, it provides access to banking services and in some cases interest payments. Toby plan is that the banks’ assets will be used to pay off the national debt. That should lead us to ask: what role are those assets currently employed in? The answer is that they provide the income that is used to provide free banking services and interest.
It’s the income from a bank’s assets that funds free services and interest-bearing accounts. If the Baxendale plan were enacted then this stream of income would dry up. Banks would have to start charging fees for services and stop paying interest on balances in on-demand accounts. It’s difficult to estimate what the effect of this change would be. Some people would be indifferent to the change, those who use few banking services and don’t qualify for interest-bearing accounts, for example. It’s doubtful though that every account holder will fall into this category — if they did then these extra services would never have been commercial successes in the first place. Many other account holders will be sensitive to this change. I myself have been a user of interest-bearing on-demand accounts for more than a decade; I’ve always used a portion of my balance as savings.
Let’s suppose the plan is enacted and interest payments cease. Those savers like me who hold balances in on-demand accounts in order to receive interest will have to change our ways. The change will be permanent: the type of saver who once held a large balance in an on-demand account as an investment can no longer exist. Consequently, there will be a fall in the demand for these accounts’ balances when the plan is enacted. This is a fall in the demand for money. The savers in question will invest elsewhere, in interest-bearing bonds for example. Banks today offer notice accounts where the account holder must give a few weeks notice before they can withdraw. The Baxendale plan doesn’t extend to timed savings, so these accounts will operate as before; they are the obvious alternative to on-demand accounts.
Higher charges for banking services will also have widespread consequences. Businesses and individuals will have an incentive to avoid using banks for payments and transfers. Alternative methods of payment will become more attractive. Businesses will be more likely to use debt agreements and reciprocal cancellation. Suppose two wholesale companies A and B regularly trade with each other. Before the plan they make payments using bank services. After the plan they decide this method is too expensive, so they each keep a record of the debt that is owed to them by the other. Then at a regular interval they settle the net debt using money or bank transfer . This will also cause a reduction in the demand for money.
The purchases of alternative investments will trigger what is called an injection effect. The type of saver I mention above will withdraw a part of his or her balance and put it into other investments. That extra demand will raise the price of such investments. The sellers of these investment products will receive that money and spend it themselves causing further price rises elsewhere. The sellers of these investments are not required to store the money they receive, they can spend it on investment projects. In time the money will spread through a large swath of the economy and price inflation will result. It’s a very similar situation to an injection of money by the central bank. These price rises will impair the planning and economic calculations of all individuals and businesses.
To recap, my opinion is that the Baxendale Plan would lead to damaging price inflation. By removing the extra services that bank accounts provide the plan will cause a fall in demand for money. If the stock of money remains the same while the demand for it diminishes then the value of each unit of money will fall.
Toby Baxendale’s Responses
Toby doesn’t agree with my criticism, we discussed this by email. Toby gave four counter-arguments:
Toby suggested that after the plan banks will use free services and possibly interest payments to attract customers. Toby wrote:
“Banks should charge for services rendered, why not? Maybe they will choose to subsidise the custodianship of cash storage. I sell fish for a living and to get hotels and restaurants to buy all of our fish species we sell, we have to discount the fastest moving lines, for example the salmon, and sell for virtually nothing. We are happy to do this as we work our margin in on the less important lines to our customers. Tesco sell cans of beans at £0.07p. This can not be even covering direct costs, but it gets people to walk into their store to buy other things that they make a full and sustainable margin on.”
This is called “loss leading”, a business offers a product or service at a loss in order to attract customers and build up a relationship with them. This hopefully gives the business an opportunity to sell them other products and services that are profitable. I agree that banks are likely to do this.
But, on-demand accounts attract customers to use other banking services now under the existing banking laws. What we should examine is the change: how would things change if the Baxendale plan were implemented? The situation at present is that a bank gains in two ways from offering on-demand accounts. Firstly, the bank can lend out the funds it receives from account holders, secondly, the account services can be used to attract customers towards other services. If the plan were enacted then afterwards only the latter incentive would apply. So, I think that if the plan were enacted then the provision of free banking services would decline, all other things being equal.
The Scale of the Problem
In Toby’s opinion the size of the effect I’ve described here would be small. If the total sum of balances in interest-bearing on-demand accounts is small then the cessation of interest would not have a great effect on the wider economy. Toby found some statistics on this from the Bank of England , these show that in March there was £386 billion in on-demand accounts that pay interest. As discussed above quite a large proportion of that amount would remain in on-demand accounts after the plan is enacted, though it’s impossible to accurately predict the proportion. However, I think it’s still useful to compare this figure to the stock of money-in-the-broader-sense. Anthony Evans and Toby Baxendale have made a measure of the UK money stock that’s consistent with the concepts of Austrian Economics . By this measure the money stock is presently about £1 trillion. So, interest-bearing balances make up approximately a third of the total. The Bank of England use a different measure – “M4” – which is based on different principles. According to that measure the money stock is about £2.2 trillion. I’ll concede that if the arguments put forward by Austrian economists against the M4 metric are wrong then I’m wrong about interest-bearing accounts. But, I think the arguments make by Frank Shostak  against the M metrics are persuasive.
However, interest payments are only one part of the issue, the cost of banking services is the other. If the banks were to significantly raise the fees for their services then the demand for balances in their accounts would fall. This depends, to some extent, on how the banks decide to charge. If the banks were to charge a monthly storage fee proportional to the account balance then that would be akin to a negative interest rate. That would be a strong incentive not to hold a large balance, but other charging schemes would have a similar albeit lesser effect. There are several historical precedents for this, Irving Fisher wrote about some of those in his booklet “Stamp Scrip” . Fisher thought that reducing “hoarding” of money could be economically beneficial, I disagree. But, he provides evidence that charging for storage of money reduces the amount of it that people hold.
Price Deflation Afterwards
“With a fixed money supply, the ongoing productivity gains by the entrepreneurs means that more goods will be offered for sale at better prices, this means the purchasing power of money has gone up. As this is the only way that we have economic progress with a fixed money supply, people will be more fixated on what their money buys rather than what the numerical value is supposedly going up by.”
In the long run Toby is correct, but, in the short run the purchasing power of money is affected by the demand for money. Steady price deflation could occur in the long run after the short term effects I’ve discussed here have played out. But, the stumbling block is the period directly after the plan is enacted. If I’m right and price inflation occurs then the government may call a halt to the plan and reintroduce the current banking system.
Effect of the Plan on Production
“I concur with you that price realignments will take place as people adjust to the brave new world. This is wholly right and good, as what consumers want will be more aligned with what producers produce. What producers produce will correspond more closely with what savers want to buy when they spend their money. Only bubble based activity will be deprived of credit.”
Here Toby is referring to the Austrian Theory of the Business Cycle. That theory indicates that if the quantity of money and the demand for money remain stable then unsustainable bubbles become much less likely to form. But, like the price deflation argument this is a long term theory. It can’t tell us what will happen while the demand for money is settling down from the initial disturbances caused by the implementation of the plan.
I’m sure lots of people will have opinions about this, and there are many more questions that remain to be explored. I think it’s likely that there is no way of transitioning to a better monetary regime without disturbances. However, we should endeavour to predict what disturbances may occur and plan for them. For now we can continue the discussion in the comments thread below.
References Ludvig Von Mises “The Theory of Money and Credit” Liberty Fund Edition, p.170.  ibid, p.154.  Murray Rothbard “The Case Against the Fed”, p.34.  Ludvig Von Mises “The Theory of Money and Credit”, p.314-315 describes cancellation in more detail.  Bank of England “Monetary & Financial Statistics May 2010” table A6.1 column BF96 p. 52.  Anthony J. Evans & Toby Baxendale “The monetary contraction of 2008/09: Assessing UK money supply measures in light of the financial crisis”  Frank Shostak “The Mystery of the Money Supply Definition” The Quarterly Journal of Austrian Economics vol.3, no.4 (Winter 2000).  Irving Fisher “Stamp Scrip” this booklet is no longer in print. It is available here.